Abstract
The central issue of this paper is analysis and resulting proposals to help unsophisticated pension participants achieve pension portfolios that match their level of risk aversion when there is a large amount of unexplained heterogeneity in risk aversion. Target date funds are commonly used as the default investment in defined contribution plans in the U.S., UK and other countries. These funds recognize that individuals usually should hold less risky investment portfolios as their expected retirement date approaches because their ability to bear financial market risk declines as the time horizon decreases. However, these funds do not account for differences in risk aversion among people with the same target date. Empirical studies find large amounts of unexplained heterogeneity in risk aversion. Target date funds cannot deal with this issue simply by sorting people into demographic groupings, other than age, that are known to affect risk aversion, such as gender. Financial education can help people do a better job of managing financial market risk in their pension portfolios, but we argue that it is unreasonable to expect millions of pension participants to attain advanced levels of financial literacy. This paper considers three innovations in target date funds that can help individual pension participants do a better job of managing financial market risk. The analysis can be applied to other situations where defaults are used for investing pension participants’ portfolios. The paper suggests new lines of research relating to individual differences in risk aversion.
Highlights
While financial education to provide a basic level of financial literacy is desirable, it is unreasonable to expect millions of people to achieve the level of financial literacy needed to construct well-diversified, low-fee portfolios that are appropriately aligned with each person’s riskaversion level
The central issue of our paper is analysis and proposals to help unsophisticated pension participants achieve pension portfolios that match their level of risk aversion when there is a large amount of unexplained heterogeneity in risk aversion
The problem can be simplified by investing the entire pension portfolio in a target date fund, but in that case, it is assumed by the target date fund provider that the level of risk aversion is only affected by the person’s expected retirement age ar, which translates into their expected year of retirement
Summary
A key element of the argument of this paper relates to the empirical evidence as to heterogeneity in risk aversion. Watson and McNaughton (2007), in an empirical study of employees of Australian universities, find that though the gender difference in risk aversion is statistically significant, its economic impact on portfolio selection is small. In their regressions, the adjusted R2 is low, never exceeding 0.03, indicating that most of the variation in risk aversion is unexplained by their explanatory variables, including age, gender, and income. They find that one-time financial education programs tend to be ineffective, but that programs that provide follow-up tend to be more effective
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